Economic Flash: Resilience But Without Much Help from the Fed 

May 2024

US Economy: Good news or bad news?

April was marked by signs of economic resiliency in the U.S. economy: Manufacturing activity (+50.3) surpassed expectations, unemployment ticked down (3.8%) and retail sales (+0.7% MoM) accelerated. Meanwhile, hotter inflation metrics (+3.8% Core CPI YoY), disappointing advance estimates for U.S. GDP growth (+1.6% Q1) and weaker existing home sales (-4.3% MoM) painted a less optimistic picture but one that likely doesn’t motivate the Fed to quick rate cutting action.

US Stocks: Down most since September.

With inflation stickier and confidence in substantial Fed support on the ropes, U.S. equity markets gave back some of the robust gains notched in Q1. All sectors fell during the month except utilities (+1.7%) on its defensive characteristics although strong earnings results from Alphabet (+7.9%) buoyed communications while energy (-0.8%) benefited from tight supply. Small-cap stocks fell in tandem with their larger peers.

Foreign Stocks: China finally gets a bump.

Non-U.S. developed stocks performed similarly to their U.S. counterparts with every developed region in negative territory, but a few outliers buck the trend such as the UK (+1.9%) as business activity increased at its fastest pace in a year. Previously the YTD laggards, emerging markets stocks better held their value with strong results from China (+6.6%) on government measures announced to ease home purchase restrictions in many markets, bringing optimism to the moribund real estate market.

Fixed Income: Rates back on the rise.

Interest rates resumed their rise in April with the 10-year U.S. Treasury yield at one point topping 4.7%, the highest level since last November. Meanwhile, yield spreads remained tight, lending support to credit markets despite the most corporate defaults through this point in a calendar year since the Global Financial Crisis. As a result, securities with less interest rate sensitivity, such as shorter maturity bonds and higher yielding corporate bonds, were the strongest performers.

Real Assets: Infrastructure brings the support.

Commodities (+2.7%) were the strongest performers in the asset class with the price of gold (+2.5%) again performing well as speculators bet on rising uncertainty and a weaker U.S. dollar. Infrastructure assets, both broadly (-0.6%) and renewables (+0.2%) as a subsector, held up better than other equity-oriented segments because of their better valuations, defensive characteristics and the long-term secular demand supporting each category.

Alternatives: Focus on distressed credit.

Hedge funds shouldn’t be expected to keep up with equities in the short-term but they should be expected to improve a portfolio’s risk-return profile to deliver better long-term results. To that end, fund managers have taken advantage of an environment characterized by higher rates and volatility to generate attractive returns even if this month that meant a flat result. Absolute return-oriented strategies outperformed equity oriented-strategies with equities falling during the month.

Source of data: Bloomberg

Equities Total Return

U.S. Large Cap (4.1%) 6.0% 22.6%
U.S. Small Cap (7.0%) (2.2%) 13.3%
U.S. Growth (4.4%) 6.3% 30.7%
U.S. Value (4.4%) 3.9% 13.4%
Int’l Developed (2.6%) 3.1% 9.3%
Emerging Markets 0.4% 2.8% 9.9%

Fixed Income Total Return

U.S. Agg. Bond (2.5%) (3.3%) (1.5%)
TIPS (1.7%) (1.8%) (1.3%)
U.S. High Yield (1.0%) 0.5% 8.9%
Int’l Developed (1.5%) (2.3%) (0.6%)
Emerging Markets (0.4%) 1.0% 5.5%
Intermediate Munis (0.8%) (1.1%) 1.6%
Munis Broad Mkt (1.1%) (1.4%) 2.2%

Non-Traditional Assets Total Return

Commodities 2.7% 4.9% 2.9%
REITs (7.9%) (9.1%) (0.8%)
Infrastructure (0.5%) 0.8% 0.9%
Hedge Funds
Absolute Return (0.1%) 1.7% 4.6%
Overall HF Market (0.4%) 2.1% 4.8%
Managed Futures 1.8% 11.7% 11.4%

Economic Indicators

APR-24 OCT-23 APR-23
Equity Volatility 15.7 18.1 15.8
Implied Inflation 2.4% 2.4% 2.2%
Gold Spot $/OZ $2286.3 $1983.9 $1990.0
Oil ($/BBL) $87.9 $87.4 $79.5
U.S. Dollar Index 123.3 124.1 119.4

Glossary of Indices

Our Take

The phrase, “April showers bring May flowers” has always rubbed me the wrong way. Perhaps it is because my birthday is in April and, growing up in Seattle, it has more often than not meant the candles on my cake were going to have to be blown out indoors. As an adult, still living in Seattle, it is a hopeful euphemism for patience in a climate where spring tends to arrive a bit later than most would hope. It could also be the mantra of investors in the current environment. 

As we survey financial markets, the outlook for both inflation and Fed monetary policy remains at the forefront. Frankly, most months over the last couple of years could be characterized in some way by changing sentiment on those topics. Still, investors have been eagerly anticipating that the Fed would see modestly deteriorating economic data alongside slowing inflation and would support markets by lowering interest rates. With inflation by most measures persisting a bit higher than hoped, investors will likely have to remain patient (and suffer a bit more rain) before the Fed brings up the flowers.   

To that end, Fed Chair Jerome Powell cited a “lack of further progress” in bringing down inflation in comments from early May to support an ongoing wait and see approach to interest rates. However, on the positive side, he suggested the committee did not believe more interest rate hikes would be necessary and that it would be quick to act should a rapid deterioration of the labor market unfold. Financial markets have noticed the inflation data and changing Fed sentiment and they are now pricing in only about one interest rate cut before the end of 2024, a marked change from six back in January. 

What this means is that the U.S. economy, which, as referenced above, cooled to a 1.6% annualized pace in Q1 down from 3.4% in Q4, will have to stand on its own without the expectation for the Fed to step in meaningfully. Can it? It is important to note that one of the reasons the Fed isn’t acting is because economic data really hasn’t weakened as much from the previous interest rate hikes as might have been expected: The U.S. economy is still growing and the labor market is stable while consumers and the real estate market have both proven remarkably resilient in the face of a much more difficult financing environment.      

What Now 

So, if the Fed will be on the sidelines, what are we paying attention to and what could knock the U.S. economy and markets off course? Our view is that of all the risks in financial markets, the drivers that are the most likely candidates are: 

  1. Higher interest rates start to take a more dramatic effect on consumption and business activity.
  2. Geopolitical risk, including the seemingly omni-directional unfortunate conflicts in Ukraine, the Middle East and possibly Taiwan, all of which could lead to disruption of trade and supply chains along with rising uncertainty and volatility. Moreover, the U.S. presidential election as well as other consequential elections around the globe will have meaningful ramifications for fiscal policy and trade.

It is the second of these drivers that is most likely being underappreciated by financial markets today, as investors may be too focused on the Fed lowering interest rates to acknowledge the actual possibility of an economic soft landing. To that end, we are now seeing investors reward companies with stronger fundamentals rather than getting caught up in the momentum of the AI story, which is a sign of equity market health.  

In the meantime, it is fair to say that the assets that appear most attractive to us on a risk-adjusted basis are those that help diversify the equity risk in our portfolios, which generally look expensive despite pockets of value in international and small-cap equities. It may be a prudent time to top-up bond exposures within core fixed income, arguably our best diversification lever, that are likely to benefit if economic conditions and market sentiment deteriorate.